What is an Interest-Only Mortgage?

Introduction

An interest-only mortgage is a home loan with a twist: For a few years, you can make very low payments that only cover the interest owed. These lower initial payments may last for as long as 10 years, but after that you’re required to start making payments toward the principal balance.Following that period, you can either refinance, pay the remaining balance in a lump sum or begin making regular monthly payments. In this PDS blog, we discuss all things interest-only mortgages.

What is an Interest-Only Mortgage?

Interest-only mortgages are nonqualified mortgage loans, which means they come with features that can be considered risky. These include the interest-only period itself as well as, in some cases, a balloon payment. For this reason, interest-only loans don’t qualify for government-backed programs, like FHA, VA or USDA loans. Let’s say you take out a 30-year interest-only mortgage with an initial 5-year interest-only period. Your principal payments would be amortized over the remaining 25 years of the loan term, rather than all 30 years. In essence, you’re pushing the bulk of your mortgage payments to the back end of the deal.

There are two different periods that make up the borrowing term for an interest-only mortgage loan. First is the initial period, which typically lasts three to 10 years, you’ll only make payments on the mortgage’s interest. Your payments won’t reduce the principal balance or build equity in your home. However, you may still build equity if your home’s value rises over that time period.

Then there is the repayment period, when the loan will convert to an amortization schedule. You’ll make larger payments that go toward both the principal and interest for the remainder of the loan term. Alternatively, you may have a balloon payment due at this time. 

Interest-Only Mortgage Rates: What They are and What Determines Them

The rates on interest-only loans tend to be a bit higher than 30-year conventional mortgage rates. Just keep in mind that the longer your interest-only period, usually the higher your interest rate will be.In addition, once your interest-only mortgage rate begins to adjust, it’ll fluctuate with the broader market. 

The current mortgage interest rates forecast is for rates to gradually drop over the remainder of this year — but where the market will stand in five, seven or 10 years, no one knows. That’s why your best bet  is to make sure you can afford the payments even if the rate adjusts up to its maximum. Mortgages are built to be paid off over a certain amount of time, with some common timeframes being 30 years and 15 years. 

The Best Ways to Pay Off an Interest-Only Mortgage

There are benefits to paying off your mortgage early. You’ll save money by making fewer interest payments, and free up some of your paycheck by eliminating a major monthly expense. There are a number of strategies for building your equity and paying off your mortgage faster:

1. Refinance to pay less interest. You could also refinance to a shorter term, cutting down the repayment timeline. By paying off the loan faster, you’ll eliminate years of interest payments.
2. Make larger payments. Paying more can be a good option, provided the extra money is applied to your mortgage principal.
3. Switch to bi-weekly payments. Rather than saving up to make one extra payment, you can also switch to bi-weekly payments, which over the course of the year would be equivalent to an extra month’s mortgage payment.
4. Selling the home. If you sell your home, you may pay off your mortgage with the proceeds from the sale.

Conclusion

There are a lot of options out there to choose from. When deciding what option is best for you, you will have to analyze your full financial situation. Evaluate your needs, explore all terms and conditions, and identify the pros and cons. With the right information and support, you can confidently select the loan that best fits your needs and achieve your financial objectives.

Needing debt resolution support? Contact PDS today!